How to Find Cheap Stocks in an Expensive Market
As my colleague John Persinos succinctly stated earlier this week, the stock market’s rich valuation is not supported by near-term earnings expectations. Corporate profits are expected to decline by nearly 3% when companies release their Q2 results starting later this month.
In theory, the current price of a stock reflects the present value of a company’s future profitability. The faster profits are expected to grow, the bigger the premium investors are willing to pay for them. Conversely, when profitability slows down, the less of an earnings multiple investors should pay. But that’s not what’s happening now.
In fact, just the opposite is the case.
The first half of 2019 couldn’t have gone much better for the stock market. As recently reported by Robert Rapier, every sector of the S&P 500 increased in value during the first six months of this year.
All of the major market indexes hit record highs during the past month. That means in absolute terms, stocks are more expensive than they’ve ever been. So it’s only fair to ask, is there any value left to be found in this market?
The short answer is yes, if you know where to look for it. Below, I’m going to show you how.
When the stock market gets frothy, I turn to my IDEAL Stock Rating System to help me identify undervalued stocks. The IDEAL system scores every S&P 500 stock in three categories:
- dividend yield compared to treasury curve
- change in net operating cash over the past three years
- relative valuation as measured by FPE (forward price-to-earnings ratio)
The highest score a stock can receive is 10, and the lowest is 0. At the start of this week, the average score for the entire index was 4.5. That’s a little below average, but well above the 4.0 level that suggests a major stock market correction may be imminent.
I exclude the real estate sector from this exercise since REITs (real estate investment trusts) play by a different set of rules due to their tax-exempt status. I also ignore the utilities sector due to the heavily regulated nature of its profit potential.
However, there is a considerable variance from one sector to the next. Of the eleven GICS sectors that comprise the S&P 500, three of them — energy, financials, and consumers staples — have IDEAL scores above 5.0 suggesting they are undervalued.
Within each sector, some stocks score higher than others. For example, the highest rated stocks in the energy sector include Haliburton (NYSE: HAL), Marathon Petroleum (NYSE: MPC), and Phillips 66 (NYSE: PSX), each earning a perfect IDEAL score of 10.
That does not necessarily mean they are certain to rise in value, but it does suggest that the odds are more strongly in their favor.
Only two stocks from the consumer staples sector also earn an IDEAL score of ten: Altria Group (NYSE: MO) and Kraft Heinz (NSDQ: KHC). Of course, KHC got slammed five months ago when it took a $15 billion write-down. But now that its share price is 20% cheaper, this may turn out to be a great time to buy it.
Somewhat surprisingly, the financials sector has the most stocks with the highest possible IDEAL rating: Ameriprise Financial (NYSE: AMP), Comerica (NYSE: CMA), Morgan Stanley (NYSE: MS), Prudential Financial (NYSE: PRU), and Unum Group (NYSE: UNM).
In case you’re wondering, those 10 stocks from just three sectors account for half of the entire S&P 500 companies with a perfect IDEAL score. The other half is spread across seven of the remaining eight sectors.
That means there is relative value to be found in almost every sector of the stock market. Although the health care sector appears overvalued, there is one company within it — AbbVie (ABBV) — that earns a perfect IDEAL score of 10.
But since ABBV’s sector score is so low, now may not be the best time to buy it. Instead, I would focus on the 10 stocks above with perfect scores that are in sectors that also appear to be undervalued.
Okay, so now that we know where to find value in this market, how do we cash in on it? Of course, you could simply buy the stocks and wait for them to appreciate.
That approach is fine if you have a long-term time horizon. Eventually, stocks with high IDEAL scores are recognized by the market.
However, that process can sometimes take years to play out. I added Best Buy (NYSE: BBY) to my growth portfolio four years ago when it achieved a perfect IDEAL score of 10. Over the next 18 months, it declined in value while the overall stock market was on the rise.
As you might imagine, some of my readers were getting antsy.
Since then, BBY has more than doubled in value to vindicate my faith in it. It took some time for the rest of the market to recognize the hidden value in Best Buy that I already saw. But once it did, the herd mentality took over and it has been a stellar performer ever since.
You may not feel like waiting around for a year (or more) to see your investment pay off. In that case, I suggest you add a seasonality indicator to your stock selection process. My IDEAL system does not have that, but I know someone whose system does.
My colleague Jim Fink runs a trading service with an uncanny ability to pinpoint investments that generate steady profits in up, down or sideways markets.
Jim’s investment system hands out a regular weekly payment to his followers, sort of like a “paycheck” that they can count on, week in and week out.
We’ve just released Jim’s new presentation. It explains how investors just like you can use one simple technique to earn steady income payments of $1,150, and $1,500, and even $2,800… every single week.
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